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Izabella Kaminska (Bloomberg) | Aug 31, 2022
Despite all the innovation in the app economy for matching supply and demand for physical services (think: Uber surge pricing), there is no equivalent for balancing distortions in funding markets in real time.
The world of “intraday” funding — i.e., cash borrowed during the day as opposed to overnight — remains highly dependent on excess liquidity from central banks, even as Federal Reserve officials move to accelerate the rate at which this is to be withdrawn over September and October. Once this de facto free liquidity is retracted, funding shortages could easily appear again, potentially toppling over into overnight and longer-term markets. If they do, market participants will have to come up with their own solution — or go cap in hand to the Fed and risk stigmatization.
Believe it or not, the world of crypto — which has never had recourse to a lender of last resort — can now be looked to for inspiration on how to navigate this tighter environment.
Take, for example, the perpetual swap (or perpetual future as it’s also known). Since its creation in 2016, it has become hugely popular in the highly parochial world of crypto trading due to the way it allows speculators to take synthetic positions that avoid the risk, cost and friction associated with having to move or manage actual cryptocurrency, which can be hacked, mismanaged or inaccessible if a password is lost.
Unlike conventional derivatives, the perpetual future never deviates from the spot price of the crypto it is referencing. Usually, if you trade one-month, two-month, or three-month futures of anything, the price will reflect premiums or discounts relative to the reference price — something known as basis. The perpetual swap’s design, by creating an active price for intraday funding, prevents that.
The combination of being able to trade crypto synthetically and without basis cost has helped turn BitMEX, the derivative exchange that first introduced the contract, into a key destination for crypto trading and a billion-dollar enterprise. The perpetual swap has since been replicated at many other exchanges in response to popular demand from users.
And yet, despite becoming one of the most important financial innovations to come out of the crypto space, the perpetual swap remains largely unknown in the world of traditional finance. This is mainly because the role that the contract plays in pricing intraday crypto vs. dollar liquidity is not well understood, even by crypto traders who use the contract frequently.
This especially applies to the mechanics of the premium index, which the contract is inadvertently underpinned by. The concept for the index hails from the fact that Ben Delo, the BitMEX co-founder most responsible for the perpetual swap’s invention, realized that if he was going to remove basis risk from the equation, he would have to get traders to pay for it separately. (In February, as part of a negotiated settlement, Delo and his BitMEX co-founders plead guilty to violating the US Bank Secrecy Act.)
In Delo’s mind, if traders who wanted to be long the market were forced to pay an active funding rate to those taking the opposite view just to keep positions open, this would encourage customers to take the other side of the trade. The process would balance the system and tether the perpetual contract with the spot price of bitcoin. The premium index was the means by which the funding rate was determined, and it was drawn from the degree to which the perpetual contract was trading over or under spot at the current funding rate. Any differential would then be used to adjust the funding rate for the next eight-hour period.
It is this kind of open-source mechanism that could be applied to conventional FX swap markets (and others) to help traders navigate tightening funding conditions. Just like with Uber’s surge-pricing system, if and when an imbalance manifested, they would be paid by the market to take the other side — returning the market to balance quickly. In theory, this would reduce the risk of short-term liquidity shortfalls turning into much broader systemic liquidity issues further down the line or ones that need plugging by more formal central bank channels.
So far, JP Morgan Chase & Co.’s attempt to develop an internal “coin” to smooth the bank’s own internal funding imbalances comes closest to any serious effort to address similar issues in the financial system. The bank has been motivated to do this because it is already a de facto “second to last resort” lender to the market due to boasting excess liquidity on its balance sheet more often than not. That means before banks even think about going to the Fed’s overdraft facilities, they usually attempt to borrow from JP Morgan.
But being beholden to just two major lenders on an intraday basis is far from ideal. Adapting innovations such as the perpetual future system to dollar markets would increase options for accessing liquidity in the event of a major dollar shortfall, which becomes an ever greater possibility without the buffer of excess reserves.
It’s important to remember that all overnight funding issues originate from intraday ones that cannot be matched effectively in time. The only reason the market never engineered its own tools to better trade intraday funds is because there was little to no stigma from using Fed overdraft facilities up until the global financial crisis. Since then, quantitative easing has obscured the imbalance issue. The Fed’s tightening path, however, is likely to change that.
Luckily, thanks to the perpetual swap, we have the tools to trade intraday funding more efficiently. They should be creatively deployed as soon as possible.
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